Why Trade Deficits DO Matter

‘Seriously, what does Australia have to do to generate a trade surplus? For August, the deficit was $815 million seasonally adjusted. For the past three months it’s totalled $2.7 billion. And that’s with very strong iron ore prices and volumes. When is this mining boom meant to pay off?

‘Luckily, the rest of the world doesn’t seem to care right now…‘

Greg never gives up. Whether it’s supporting the Blues in State of Origin or cheering on Aussie exports…

A trade deficit means we’re buying more from overseas than we sell. To make up for the difference, we must compensate elsewhere by increasing our debt, or selling assets outright. Thanks to years of persistent trade deficits, Australia is now paying around $35 billion per year to service the resultant debt.

To be honest, we don’t understand the point of having a national border, let alone national trade data. Why does it matter if an imaginary territory called Australia buys more goods and services than it sells? Nobody gets grumpy when the same happens between Queensland and Victoria, or the electorates Fairfax and Fisher.

We bet almost every household in Australia runs a trade deficit. It buys more goods and services than it sells, with expat workers heading ‘overseas’ every morning and repatriating their ‘foreign earnings’ to make up for the difference. Meanwhile, Aussie companies do the opposite, running chronic trade surpluses. But nobody laments the imbalance. In fact, it’s seen as a good way of structuring things, as long as the imbalances are within Australia.

That’s a very abstract point though. Most people think in terms of countries instead of individuals or households. In that case, the trade deficit is actually a symptom of instability in other areas. One example is the gap between savings and borrowings which too much consumption creates. An economy needs savings for the same reason a household does, to buy capital goods that improve productivity. Without savings, productivity stalls and an economy can only grow by increasing its population (or by borrowing more). Economic growth is overrated by many, but is incredibly important when you’re in debt.

That’s because you’ve got to repay your borrowings plus interest. If your economy shrinks and productivity stalls, that’s more difficult to do. So how you invest the borrowings is important too.

Cue the property debate, which rages on. Every commentator continues to focus on everything but debt. Stephen Kirchner explains in the Australian Financial Review how a lack of supply is the problem that leads to higher prices. And the Australian Bureau of Statistics reports August building approvals came up short on estimates.

Record house prices should lead to surging supply…in a free market. With the price of debt at a recent record low too, you’d think we have the perfect set up for a bubble. Restricted supply, cheap debt and a nation of house price speculators.

The question is which part of the bubble we’re in. The beginning, middle or end. On the one hand, prices are already outrageous. But interest rates are still on a downward path. We’re not an expert on zoning laws and the restrictions on construction. Let us know what’s holding back housing supply by emailing letters@dailyreckoning.com.au. According to some American academics, the difference between the US states that experienced a housing bubble and those that didn’t was zoning laws. Countries with restrictive ones had a boom and a bust because supply and demand weren’t allowed to reach an equilibrium.

Unfortunately, we can’t avoid the topic du jour. The latest on the sovereign debt crisis in the US…err we mean ‘the government shutdown‘…is that the nation’s bankers have been called in to fix things up.

Obama sent out the cry for help in an interview, saying that this time, Wall Street needs to be ‘concerned’ about the impasse. Shortly after, Goldman Sachs and JP Morgan sent their CEOs to the rescue. They explained to the media that, as bankers, they would have a sophisticated understanding of the consequences of a government debt default.

After all, both companies almost went bankrupt themselves recently. Who were they saved by again? Who dominates political donations to politicians in the US?

We expect that a lot of back scratching is going on behind the scenes.

Meanwhile, one of those ignored important events we mentioned is slowly taking place in plain sight. Our sister publication in the US, the 5 Minute Forecast, points out that foreigners are selling US government debt at a steady pace.

And this is another place where trade deficits do matter. They create a lack of savings and funds at home. If your government is running a deficit too, somebody else needs to finance it. The less keen they are, the higher the interest rates they demand. If Americans begin to rely on their own savings to buy up their government’s debt, that’s going to bite into consumption.

For some reason, economists believe that when you save money it disappears from the economy. Keynes called it the Paradox of Savings. Of course, saved money doesn’t disappear, it is borrowed by someone else. It’s used to grow the economy. Especially if a business borrows the savings to finance a new machine that improves productivity.

But if those borrowings are used by the government, that’s not very likely to improve productivity. Which is why the US is in such a pickle. The government is soaking up the capital the country needs to recover.

And that’s where the Federal Reserve comes in. Oh boy, almost a whole Daily Reckoning without mentioning the Fed once!

Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it.
To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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